Dangers of Do-It-Yourself Estate Planning

Occasionally, people who are not estate planning attorneys will attempt to draft and implement their own estate plan. Often, they erroneously believe they can find a document online or use a friend’s legal documents and can figure it out. Unfortunately, there are many pitfalls one could run across when they try to develop a Do-It-Yourself estate plan.

Let’s look at three (3) significant problems they will encounter, as many coupes often do when preparing their own estate plan, without the advice of a competent estate planning attorney:

Problem #1:

Bill and Mary have a house worth $500,000, an IRA valued at $500,000, and non-qualified investments of $500,000. They have three children, Aaron, Betty, and Charlie. At the death of the survivor of Bill and Mary, they want to leave the house to Aaron, the retirement plan to Betty, and the investments to Charlie.

The first problem with this plan, assuming they draw up the proper legal documents to accomplish this distribution pattern, is that they may not have considered the downsides. More specifically, Bill and Mary’s plan did not anticipate that they might sell their house in the future, which they did. As a result, the specific bequest of the house to Aaron lapsed. 

Upon the sale of their house, this couple added the net proceeds from the house to their investment account. Since their plan left the investment account to Charlie, those assets went to him instead of Aaron, which was not consistent with their desires for the distribution of their estate upon the passing of the surviving spouse.

Problem #2:

The second problem with this plan, even assuming they prepared their estate planning legal documents which accomplish their desires, is that they have not considered the income tax implications. 

While their three assets may have the same value currently, the house and the investments get a step-up in basis at death. In other words, when the beneficiary of these two assets will not owe income tax on them. However, the IRA is deemed under federal law to be “Income in Respect of a Decedent” or “IRD,” which is an exception to the step-up rules. 

Assuming Betty has a combined marginal federal and state income tax rate of 40%, $200,000 of the IRA would be lost to income taxes. Therefore, it might have been better to distribute the IRA to Charlie, who is in a lower income tax bracket, or in the alternate, spread the income tax consequences over all three beneficiaries. After the payment of income taxes, Betty would end up with $300,000, while each of her brothers would receive $500,000.

Problem #3:

There is a third problem with this estate plan, even assuming Bill and Mary draw up their legal documents which accomplish their goals and objectives. More specifically, this couple has not considered fluctuations in the values of their assets when they are ultimately distributed to their children. 

For example, let’s say they die ten years after they draft their estate plan and the assets are then worth $3 million. Unfortunately, their three children will not each receive $1 million. In fact, one of the children might get far less than the others. How is that possible? The house devised to Aaron could be in a neighborhood of decreasing, rather than increasing, property values, and it’s value could have significantly declined to $200,000. 

Bill and Mary may continue to contribute to their IRAs over their working years and wherein their daughter Betty is the designated beneficiary, and which accounts may be worth $1 million at the death of the survivor of Bill and Mary. 

The non-qualified investment account bequeathed to Charlie may have appreciated in value and be worth $2 million upon the death of the survivor of Bill and Mary. 

Upon the time Bill and Mary’s estate is distributed to their children, Aaron would get the house worth $200,000; Betty would receive the IRA worth $1 million (but subject to income taxation of $400,000); and Charlie would inherit the investments worth $2 million.

As a result, Charlie would get more than triple the after-tax value of his sister Betty’s IRA inheritance, and 10 times the value of the bequest to his brother Aaron.

As this edition of Estate Planning Matters reflects, estate planning is about far more than just drafting and implementing the proper legal documents in accordance with both federal and state laws. It’s also about the knowledge, experience, and prudent recommendations of the attorney who designs and implements your estate plan.